Market Indicator for the Week Ahead
February 28, 2011

VIX Spikes

Introduction of the Market Indicator

Last week finally provided some volatility in the market place. The S&P 500 Index (SPX) was down 2% on Tuesday, and then fell some more on Wednesday. Over those two days, the index fell a total of 2.6% -- which is its biggest short-term loss since last August. The CBOE Market Volatility Index (VIX), which tends to move in the opposite direction as the market, spiked higher as a result, moving up 35% over the two-day period.

The chart below shows the VIX and SPX going back to 2010. The yellow circles denote prior instances where the VIX gained at least 30% over a two-day period.


VIX Spikes

When the market begins falling, traders rush to hedge their investments to guard against a significant drop in the market. A popular way to hedge is to buy put options on the SPX. The scramble to purchase these options increases option premiums -- and, in turn, the VIX. That's why the VIX is called the "fear index." Below, we'll see how previous VIX spikes have turned out for the market.

Going back to 2000, there have been 11 other times when the VIX gained at least 30% during a two-day period. Below is a table showing how the SPX performed afterwards. All of the signals have occurred since 2005. So, for comparison, a table is included, showing how the SPX has typically performed since then.



This market indicator shows that the returns are pretty bearish for the market during the next two weeks to a month following previous VIX spikes. What is most interesting is that the two weeks later was 36% positive -- but one month later, it was 73% positive. However, the average return is very negative one month out. So, what's causing this effect? Below is a table showing each of the individual results after a signal.



There is a pretty clear divide in the table above between the returns before 2008 and the returns after. Before 2008, the big VIX spikes were nothing to worry about. All five signals before 2008 preceded a higher market one month later. Since 2008, it's been a different story. Three of the six returns have not only been negative, but they have been very negative. Two of the signals happened during the 2008 market crash, and the other negative signal happened just before the May 6, 2010 "flash crash."

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